“Capital isn’t this pile of money sitting somewhere; it’s an accounting construct.” — Bethany McLean
Given the spirit of the new year, you may have resolved to try new things, like parachuting from a plane, losing weight or quitting smoking. Or perhaps you want to apply your resolution to your business, and since today is Thursday, we’ve got bookkeeping on our minds.
In some ways, committing to a new bookkeeping method can be like jumping from a plane because your heart may end up in your stomach if you choose lightly. The two types of accounting we’ll explore are cash and accrual.
Cash: Still The King?
The cash method dictates that you must claim the company’s income when the check has been cleared in your bank account. For example, your advertising agency lands a $100,000 account in January for a last-minute project that you need to deliver by January 31. Congratulations — you still can’t claim that as income until that amount shows up in your account, which could take months. Additionally, it’s likely that will happen in installments as opposed to a lump sum. So you’ve got to play the waiting game, which can turn into a game of tag, which can evolve into a hunt.
Tender Notes On Cash Accounting
One nice benefit from this method is that the process goes both ways. If you make some big purchases or incur expenses related to the business, you don’t claim it until you pay up. Think “no payments until 2018!” You might have an easier time upgrading hardware and software and hiring in this scenario.
This is a more direct way to track your revenue — the numbers don’t lie. However, it becomes difficult to track your company’s productivity this way. January will not show the $100K in earnings because it’s not paid in that month. You or your CFO should have a finger on the pulse of income and expenses if you use this method.
A-Counting On Accrual
The accrual method records the income when it’s earned and the expenses when they’re incurred, practically regardless of when the transactions occur. I say “practically” because you need to be confident that clients will pay reasonably quickly. Using the prior example, the January contract you landed might not get tallied until the project is complete and the invoice is mailed. So it’s safer to mark the revenue for February.
Pros & Cons of Accrual
In many ways, this method paints a clearer picture of your company’s progress and revenues, as opposed to cash. You’ll know your peak performance times and will be better equipped to handle complex transactions.
Unfortunately, it’s not as clear as cash accounting in that you’re a bit removed from your actual cash flow. It’s easy to overdraw funds when employing this method because in many cases you’re anticipating payments and not cashing checks.
Both methods have their merits for small businesses. Ultimately, you know better than anyone how your business operates. After all, you may be the accounts payable department in addition to being CEO.
If you want to change accounting methods in the new year and want a qualified second opinion, contact Brinen & Associates and we’ll help assess your situation.